Investors Ignore Fundamentals

Commercial mortgage-backed securities are the prettiest pig in the pen, noted one major money manager — not pretty, just the best of what's available. Real estate fundamentals continue to be weak, but buyers still see a safe haven in the CMBS market, according to the Barron's/John B. Levy & Co. National Mortgage Survey.

Through early May, CMBS spreads had tightened four out of the previous five weeks. According to Greenwich Capital, spreads for the long triple-A tranche are at levels not seen in almost three years. Moreover, due to the light supply of new securitizations, analysts argue that spreads will stay at these low levels. Not only are spreads low, but interest-rate swaps are low as well. Currently, 10-year swaps at 36 basis points aren't too far from their all-time low of 28. As a result of low swap rates and spreads, long triple-As carry a meager yield of about 4.5%.

To date, CMBS issuance has been strong, almost $24 billion vs. $18.7 billion for the same period last year. Volume in early May was expected to be fairly modest with a surge late in the month. But even the volume at the end of May wasn't expected to roil current spreads.

Fixed-Rate Deals Overshadowed

The current market is devoted to floating-rate loans, including an $881 million offering from CS First Boston and a whopping $1.23 billion offering from Lehman Brothers. Floating-rate loans generally attract a different group of buyers than fixed-rate loans, with the triple-A buyers mainly coming from Europe. Because many floating-rate loans are secured by assets that haven't been stabilized or are undergoing some transition, the lower-rated tranches are well suited to those who understand real estate fundamentals. Borrowers seek floating-rate loans because there are virtually no pre-payment penalties to limit further refinancing.

The Lehman transaction has been causing quite a stir as some 40% of the assets are hotels, a sector prone to high defaults and delinquencies. In this offering, Lehman is including a $300 million loan on the Swan and Dolphin hotels located in Orlando's Walt Disney World, as well as a $128 million loan on 10 other hotels. The Swan and Dolphin include some 2,300 guest rooms and more than 300,000 sq. ft. of meeting and exhibition space. The events of Sept. 11 have not been kind to Walt Disney World, where attendance has dropped from 43 million in 2000 to under 38 million in 2002.

To no one's surprise, the Orlando hotel market hasn't fared well either. According to Trepp LLC, 25% of the $1 billion of hotel loans in the Orlando MSA are now delinquent. If the Swan and Dolphin hotels were removed from the equation, the delinquency numbers would increase to 35%. Nevertheless, Lehman expects the securitization to meet with investor approval, and the A2 class is thought to price at LIBOR (London Interbank Offered Rate) plus 37 basis points. This is only slightly wider than the A2 class from the CS First Boston transaction, which has a shorter average life and is expected to price at LIBOR plus 35 basis points.

A Disconnect In The Marketplace

The continuing combination of weak real estate fundamentals and tightening spreads has more than a few observers scratching their head. As one major trader noted, “We priced in a lot of good news, which feels too good to be true,” and that may well be the case. Dan Ivascyn, senior vice president for Pacific Investment Management Co. (PIMCO) notes, “While we could see a bit more tightening, any signs of economic recovery will cause an outflow of funds from CMBS into the lower quality side of corporates.”

Commercial mortgage whole loans performed reasonably during the first quarter, according to the Giliberto-Levy Commercial Mortgage Performance Index. They garnered a 1.49% total return, which was slightly lower than the 1.68% recorded by investment-grade CMBS. But neither sector was any match for the Lehman Brothers' Triple-B Corporate Index, which recorded a sizzling 3.38% return due to rapidly declining spreads.

Competition to originate new loans remains fierce. On the insurance company side of the ledger, spreads are still contracting. But for highly contested deals, there is no reluctance to slash rates. The market is abuzz with talk about a transaction with less than a 50% loan-to-value where spreads dipped to about 90 basis points.